As readers may recall, Gary Gensler of the CFTC has been fighting to implement Dodd Frank rules on derivatives, and not only is Obama pushing him out on an accelerated schedule, but European regulators are throwing hissy fits via Jack Lew over Gensler’s continuing insistence on enforcing regulations they haven’t managed to stymie intransigence.

Just as not every regulator in the US has given up on doing his job, so too seems to be the case overseas. Recall that the Treasury and the FSA in the UK pushed hard for a Glass-Steagall type split between retail banking and other operations. Concerted opposition by Treasury resulted in that being watered down to mere ring-fencing.

And now, in an amusing coincidence of timing, while one cohort of European regulators is trying (with not much success) to get Gensler leashed and collared, another has launched a major attack on a big derivatives profits engine, credit default swaps. From the Financial Times:

Investment banks’ 20-year grip over credit insurance markets has come under regulatory assault as Brussels served charges against 13 banks for allegedly conspiring to block exchanges from challenging their business model.

The formal European Commission charge-sheet, running to almost 400 pages, alleges collusion to ensure the insurance-like contracts remained an “over-the-counter” (OTC) product – preserving the banks’ lucrative role as middlemen.

Investigators claim the banks from 2006-2009 protected their indispensable position in the $25tn global market through “control” of a trade body and information provider, which vetted whether new exchanges should be licensed…

Brussels alleges that the harm from blocking exchanges, such as Deutsche Börse and CME Group of the US, went beyond trapping investors in the relatively more costly OTC market.

Joaquín Almunia, the EU’s competition chief, said keeping CDS in the opaque OTC market weakened the financial system, increasing counterparty risks that were brutally exposed after the collapse of Lehman Brothers.

EU authorities said Markit and ISDA—which are providers of data and licensing in the market—were at the center of the banks’ plans to prevent exchanges from getting a piece of CDS trading. The banks, the commission said, instructed ISDA and Markit to sell licenses for their data and index benchmarks only for over-the-counter trading.

EU authorities also suspect that the banks may have routed trades to one clearing house that they felt was unlikely to develop an exchange-traded CDS contract that could take business away from the banks. Clearing houses are entities that absorb losses if one of the parties to a derivative contract defaults.

This case is potentially very significant. First, the EU antitrust authorities have been bloody-minded in the past. Microsoft was fined a record $689 million for tying its media player to its browser in the early 2000s. It was then fined an additional $1.4 billion (which was reduced slightly due to an error in calculating the fine) for failure to comply with the earlier antitrust decision.

Second, as we’ve written at length (both on this blog and at greater length in ECONNED), curbing CDS is critical to reducing systemic risk. CDS are tantamount to unregulated insurance and would not be viable as a product if banks had to put up adequate margin to allow for “jump to default” risk. They are also a major source of “tight coupling” or overconnectedness among firms (in layperson speak, if one fails, the others are at risk because they have so many counterparty exposures). CDS also have no real societal value (the argument that they are a way to short bonds is spurious; CDS have a ton of basis risk on the credit front alone and are a lousy hedge of only one attribute of the risks represented by a fixed income instrument. Moroever, if you don’t like a bond, sell it. No one was howling about the absence of a way to short bonds prior to the introduction of CDS. Its raison d’etre has long been for banks to game risk-based capital requirements).

The banks have wanted to keep derivatives over the counter, particularly CDS, since those prices can’t be derived readily from published indexes or actively traded markets (which is in contrast to a lot of interest rate and foreign exchange swaps). That allows the banks to mark up the price considerably over inter-dealer levels.

And from a regulatory standpoint, CDS are one of the most important products to shrink or eliminate. As long as banks can keep writing them without having to put up adequate capital or margin, they have economic incentives to pile up more risky exposures than they can handle. The fear of setting off cascading failures was the big reason Bear, an otherwise not systemically important player, was rescued (Bear was one of the three biggest prime brokers and hence writing a lot of CDS to hedge funds). And remember CDS are almost certainly booked in depositaries (recall the controversy over Bank of America moving its Merrill Lynch exposures into the deposit book of the bank). Mind you, I’d rather see the market slowly strangled out of existence (banning it outright would be very disruptive), but moving CDS onto exchanges would reduce their profit potential to bank and lead to higher margin being charged, both of which should reduce the size of the market (higher margins would make them more costly to users, and lower profits to banks means they’d devote fewer resources to selling them).

After the protracted fight with Microsoft, the European antitrust authority said it would rely more on changes in behavior (prohibitions, in other words) rather than fines. That’s like not out of a view that the initial fines were too small but that Microsoft kept a 2004 decision in legal play for another 8 years. But the fines the EU can levy represent a sword of Damocles over these banks’ heads: up to 10% of turnover, which presumably would be the notional amount of CDS sold in the relevant time frame (2006 to 2009). Given that the market’s value was $62 trillion at its peak, the EU would seem to be able to force compliance if its charges are well documented (and although I have to confess to not having read the 400 page case yet, I suspect they are).

On a mundane level, this filing is an unexpected boon for Gensler, and should make the Administration look like the bank stooges that they are for trying to stymie him.

Most of the antitrust fight will take place behind closed doors, but I’m hoping we’ll have some fun in the form of squeals of bank consternation as they are seeing their profits shorn. It’s a long overdue spectacle.

Many people have said that it was a HUGE mistake of the ECB to bail out the OTC markets – banks were permitted to repo OTC-products as collateral for new EUR-loans – effectively turning any kind of private contract between two parties, f.eks., me and my flatcoated retreiver, into real money.

The bank lobbyists won the argument back then, but given the fraud potential, someone is perhaps seeing the light.

Another excellent article by you Yves. Who’d have thought it that financial capitalism is in danger of taking a haircut because it’s trying to evade a hallowed process of capitalism “market discovery”! Who’d have thought it that after all the pre-financial crisis Libertarian hoo-haa about doing away with the dead-hand of government regulation “big government” is the only entity left standing that actually wants to shore up market discovery processes!

1. This is a 400 page suit against 13 banks. It takes a year minimum to develop a suit like that, probably more like 2-3 years. This was not something they ginned up in reaction to the spying news.

2. Four of the 13 banks in the suit are European: Credit Suisse, Paribas, DeutscheBank, UBS. Three more are British: Barclays, HSBC, and Royal Bank of Scotland. So the US banks aren’t even a majority on the list.

We hate the EU in Britain, though the ‘reasons’ are just another tin on the hill of beans of our shame. Banks have been issuing all kinds of ‘insurance’ that looks like the old maritime scams. The idea then was to collect the fees and either run of with the cash or refuse to pay out on technicalities built into the product. The other side of this trade concerned crooks who bought clapped-out hulks and sunk them, the cargoes actually sent elsewhere on other boats (continuing today via Malta, Cyprus, Dubai and West Africa).

One has to question how insurance really works in terms of how any competitive advantage can be established, maintained and defended – a classic example of the problems involved is the US private health insurance scam. The only way to make money in insurance is to take premiums from those unlikely to need a pay out. The actuarial spreadsheet is complex and my car insurance is £200 against my 17 year old grandson at £2500. We have as many as 20% of drivers without insurance (a crime here), mostly young, so no doubt our premiums contain what they should have paid, as we are allegedly insured against accidents involving uninsured cretins. Various excess and bonus conditions mean most are not really insured for small claims. The whole system is stacked to prevent fraudulent claims, though there is a whole industry of such.
There is, of course, no need for private insurance in any field. It could be handled by a national insurance fund. If we could regulate such a scheme properly to prevent fraud, it might well be much more cost-effective than private solutions. There are many eggs to suck on here in understanding insurance before we get to what the banks are up to with CDS and the rest.
I generally prefer market solutions, but we seem to have become detached from the criminal and rigging aspects. The problem is less with regulation, and more with our inability to see white collar crime for what it is – criminal.

Throughout the private sector we are seeing Bigcorp/bank exploitation of public money to depress what should be their costs in ways that leave us with a public bill (from supermarkets paying crap wages topped up by tax credit to the bail outs). There is a long history of the frauds involved and regulatory failure. Part of this failure is the kind of after-event regulation we are seeing now. It’s like finding Ali Baba’s cave and agreeing a 10% clawback!

The truth is being hidden. How much have we had to plough into the banks – $15 trillion? What losses are still in the system – $100 trillion? What are the opportunity costs of such banking (what we might have achieved by productive investment)? We don’t even know whether we could collapse the lot in an orderly transition to modern banking and the reduction of the whole of financial services to a percentage of GDP equivalent of financial costs in a decent firm’s turnover – see all this stuff as a cost to be driven down in a really productive economy.
The crimes involved in CD (whatever) are much greater than the restrictive practice anti-competitive banking versus exchanges stuff the EU regulators may levy fines on (who pays anyway – the tax payer?) – if banks can no longer rip-off on these ‘services’ and so on how do they ‘recover’?

I’d like to see an engineered global crash of finaincial services. An intermediate step might be to let the regulators loose with fines and an equivalent transfer of bank wealth into public shares in the banks. Most of us will have seen David Graeber’s ‘Debt; the first 5000 years’ – but there is a more recent example of debt jubilee in Germany between the wars where private debt of the sort you and I owe more or less disappeared. This could be managed now without the Nazis or WW4 (3 was in Africa).

Blowback from Snowden “leaks” aiming to stymie capital flight his “revelations” were meant to provide diversionary cover for? Or does this suit possibly feed into that effort? (Still waiting for Wikileaks’ BoA bombshell, as the crisis necessitating some contrived basis for grabbing assets on the cheap by no means has passed.)

More optimistically, once the Fed is nationalized, there will be no need for Credit Default Swaps, so one wonders if Brussels possibly is seeing the writing on the wall, recognizing the Fed’s impending nationalization an effective means of slowly strangling out of existence the CDS market, while minimizing the risk of systemically threatening disruptions an outright ban would impose, and so is acting to hasten movement in this direction through this lawsuit? Can a fascist become a progenitor of republican forms of finance virtually overnight? Can a warmongerer likewise overnight become a peace-minded, republic-loving whistleblower?

Give me a break! An entire system built on a pyramid of co-dependent fantasies and you think one, or more, of the participants are about to pull the bottom layer out? Please, names and places and dates and documents or stop telling fairy stories.

Allcoppedout and TC above very interesting. I’m a dummy so I’m going to say this: This explains clearly why banksters want the OTC – it creates a smugglers haven for them. So that is cleared up. And an open exchange would let in some competition which would not thrive because risk is soon to be tempered by nationalizing central banks. Maybe. Certainly the insurance industry was the First Casino and needs to be brought under control. So then I just have to think about my favorite scam – that of commoditizing private property and fraudulently securitizing it and then getting caught and then designing their own “title insurance” company, FNF, to cover any unexpected unpleasantness, aka risk, with title claims. If the OTC market is made totally unprofitable for CDS, probably FNF won’t be riskworthy even if it is unpenetrable and offshored to English illiterates. Nevermind. Over my head.

Thank you for this informative article. Luv the anti-trust approach. Cross-applications to racketeering activities in both the EU and US across various markets, although CDS alone are a huge vulnerability, as was stated. With respect to the exchanges as the optimal solution, though, one might consider who their biggest institutional shareholders are.

I continue to agree with former Bank of England governor Mervyn King that reinstatement of a type of Glass-Steagall Act provides a superior solution. In the meantime, though, as the farmer said to the herding pig bearing the name of the title of the film “Babe”: …”Good enough, Babe… good enough!”

I am not an attorney, but I believe Credit Default Swaps are not legally considered to be insurance. Instead, I believe the banking industry’s lobbyists were successful in obtaining an exclusion of swaps from being legally defined as insurance, and instead are legally construed as contracts, albeit with super-priority in bankruptcy that gives them “financial WMD” status.

The banks are jealously trying to guard their advantage on the sell side by keeping the markets opaque and spreads wide, and taking advantage of buy side desire for cheap exposure regardless of the ultimate cost of a bet gone wrong.

Europe and Gensler are right, but luckily for the banks, memories are short and 2008 might as well have been a hundred years ago, just enough time for the banks , their lobbyists and p.r. people to distort what history to their advantage.

Nice to see the possibility finally of a beachhead in the area of CDS, which are definitely a big component in the global doomsday machine.

There is of course another reason (besides fat margins) why the banks might have good reason to want them to stay OTC, and that is opacity. If they go through a clearing house with reporting requirements and transparency, then the arguments that they are a net cost to society and increase interconnectedness will be a lot easier to support. (I for one would be following this site very closely afterward). It’s also more difficult for the banks to argue against, since if CDS actually provide a useful societal function net of costs (as they’ve always claimed) then they have nothing to fear from transparency.

If CDS become exchange traded, then they will follow the same trajectory as the regular derivatives: Either they become fully standardised and monitored by a machine-god balancing the buy/sell sides to Zero or they become like warrants, exotic crap with large spreads and little volme because of it.

In any case the banks will lose revenue and opportunities for fraud. Which they richly deserve and what is sorely needed to stabilise the economy.